We took both conventional and unconventional steps: Duvvuri Subbarao

We must understand that we can never fully insure ourselves against financial crisis.

We would have done everything that we did in real time because we were operating in real time within the universe of knowledge available to us.

Duvvuri Subbarao, the 22nd governor of the
Reserve Bank of India, described the commencement of his role as a central banker’s ‘baptism by fire’ because Lehman Brothers imploded in less than a month after he moved to Mint Street. In an interview with
MC Govardhana Rangan and
Joel Rebello, he describes how he fought the most important battle as a public servant and the lessons learnt. Edited excerpts:

Can you recall what was going on in your mind the day Lehman collapsed?

I was new to central banking and the RBI. Lehman collapsed barely 10 days after I had taken charge. In the days leading to the Lehman collapse Fannie Mae, Freddie Mac, Merrill Lynch had vanished, and AIG and some US banks like Wachovia and Washington Mutual came under pressure. There was concern in the Reserve Bank. It was like a big earthquake in the global financial sector and we saw some tremors in India too. There was concern about how our financial sector will react, what action the RBI has to take and what kind of developments will come from this…It was day in New York and night time for us.

So the first thing RBI did was to issue a statement in the middle of the night that we were watching the situation very closely and ready to take action as may be necessary. I was not quite aware of the power of central bank communication and this taught me how effective central bank communication is. The second thing we did in the night itself was to ring-fence the two subsidiaries of Lehman in India, a primary dealer and an NBFC, as a precautionary measure.

What really stands out in your mind that was the most important thing that saved the day?

I can’t say one important thing but over the three four months after the collapse, we did a number of things. It was a bewildering situation for central banks and governments everywhere and even more so for central banks and governments in the emerging markets. Not only did we have to react to what was happening in the markets, but we also had to react to what advanced economies did to meet the challenge. We did both the conventional and unconventional things. By conventional, we cut the SLR and CRR. We made foreign exchange liquidity easier by liberalising norms for ECB and NRI inflows and we cut interest rates by as much as 1% which was unprecedented. By unconventional measures, we gave lines of credit not only to banks but also to mutual funds and NBFCs.

After that as a central banker you interacted with many peers across the globe including Mr. Bernanke. What did you conclude on the genesis of the crisis?

With the benefit of hindsight, I can say there were so many causes for the crisis — the exuberance in the financial sector, global imbalances, regulatory slippages. Yes, central banks were at fault because they allowed all this financial engineering to happen, risk to build up, leverage to build up, allow the derivatives and financial engineering products. Central bankers do have to take a considerable amount of blame for developments that led to the crisis.

Was there a debate within you whether you needed to react because India did not have many derivative instruments?

Yes, certainly there was a debate on what we had to do. India was not directly sullied by toxic derivatives, our financial system was quite sound because of a number a measures introduced when Dr Reddy was the governor. Even so, it was not as if we could sit back and say there was nothing we could do because we realised that no country is an inland and it could affect every country through the financial market channel, through the economy channel because exports were taking a hit, capital was flowing back, exchange rate had nose-dived and it was impacting through the confidence channel.

In hindsight, did we at that time do more than what was required?

I don’t think so. Because the situation was so frightening that it was important for the central bank to douse the system with liquidity, run an easy monetary policy and keep assuring the markets that the RBI will take action as may be necessary. But with the benefit of hindsight, I would say that we did not unwind as quickly as we should have done.

Have the regulators learnt their lessons?

There was soul-searching, introspection, analytical studies, among central banks to learn the lessons of the crisis, there was no doubt about it. Several things happened, Basel III requirements, heightened capital norms, macro prudential regulations in addition to monetary policy, or what the regulator should do by way of countering any exuberance or excess in the financial system. There is extending the perimeter of regulation to also regulate non bank finance companies….so there were lots of lessons learnt.

Is high liquidity and asset price the signal?

Before every financial crisis, there has been an increase in leverage and asset prices but that does not mean that every time asset prices have gone up or leverage has increased, it has resulted in a crisis. Central bankers around the world have to be vigilant, cautious and have to strike the right balance between tightening policy and allowing recovery to happen.

Has the industry limited the amount of reform through lobbying?

Certainly there is lobbying but it is happening in the advanced economies. All the reforms post-crisis were in response to the experiences of the advanced economies. In India, we already had macro prudential norms because we were always regulating our NBFC sector even though advanced economy central banks got on to it later. There is now a push back in advanced economies and talk of relaxing regulations. It is a question of striking the right balance between allowing legitimate financial activity to support growth and keeping tab of financial stability.

Can there be another Lehman moment?

As a broad denominator, we must understand that we can never completely insure ourselves against financial crisis.

Have you thought about what the Indian banking system would be like if you had not reacted the way you did in 2008?

It is difficult to answer that question because there are no counter factuals in life. We had taken actions during the crisis. For example, one of the causes of the NPA problem we are facing today is the restructuring that was done during the crisis. It is important to recognise that. We were encouraging banks to restructure illiquid accounts and some insolvent accounts may have restructured as well during that time, partly because of anxiety to do something, or may be mala-fide.

So, this was an outcome of the sheer pressure or panic during those crisis times?

I would not say pressure or panic but the global financial crisis was unprecedented. So in real time we had a lot of anxiety, fear and uncertainty. Central banks and governments did a number of things in the expectation that those things were necessary. With the benefit of hindsight, it is possible to criticize that they did not do the right thing or they did wrong things or they did not do things at the right time.

Would you do anything differently if you were to do now?

We would have done everything that we did in real time because we were operating in real time within the universe of knowledge available to us. What I would say with the benefit of hindsight is that the easy monetary policy that we had run in order to manage the crisis should have been wound down earlier, faster than we did. Because we were acting in real time, because the data were telling us a different story, we could not do that. Data that came in real time were telling us that the growth was actually lower than it turned out to be afterwards. So taking into account the lower growth, we could not have accelerated the unwinding. Subsequently, it turned out that we had a V shaped recovery. If we had that data in real time, we would have unwound the easy monetary policy much faster, much sooner.